Modern portfolio theory espouses the benefits of diversification. Essentially holding a basket of securities with varying correlations should help lower volatility and enhance risk adjusted returns. It’s important to note, however, that all periods are different and diversification has helped to varying degrees over time.See Table #1 which outlines various returns on different allocations.You will note that small company stocks have historically garnered the highest annualised return but they come with higher levels of volatility. The Sharpe ratio, which measures return per unit of risk, indicates that the best portfolio since 1926 has been the 50 percent bond/50 percent stock portfolio.Traditionally bonds have offered a great hedge in bear markets. They usually rise when stocks fall, cushioning the blow from an equity bear market. Conversely, they tend to drag down overall performance in periods of stronger equity returns as their returns are less than equity gains. In the graph below which calculates bear market returns for the various periods from the 1970s and uses a traditional 60/40 “policy portfolio”, we can see that bonds have indeed provided a cushion during periods of plunging equity prices. The cushion, however, was never enough at this allocation range to tilt the portfolio into a positive return skew. See Table #2 for bear market returns.Three of these periods saw large bond gains, 1980, 2000, and 2007, but in the 1990 and 1987 bear markets, bond gains were anaemic and you still suffered about 60 percent of the drawdown. The question now, of course, is how do we expect bonds to perform in the future? Do they offer diversification and protection for any future bear market?Many would assume that the effectiveness of bonds to hedge equity downturns primarily depends on the starting bond yield and beginning year-over-year inflation rate. That is to say, in general, periods where bear markets begin and yields are high and inflation is high often leads to higher bond returns. We have run a regression on the limited data set we have and found that this relationship is not statistically significant for the period under study. What can be gleaned from the chart below is that if we were to embark on a bear market we would be doing so when the inflation level and the 10 year yield are already at lows never witnessed before. See Table #3 for bond returns vs starting inflation and yield.If we examined a worst case economic scenario it would likely produce some form of a deflationary bust. Assuming one used a ten year treasury to hedge a portfolio in this scenario it would gain a maximum of 20 percent if its yield immediately fell to zero. A 30-year treasury under the same scenario would be more effective rising 97 percent but this security also carries significant interest rate risk if yields rise. The larger risk for financial markets would be a bear market associated with some form of inflation like the 1973-1974 or even the 1976-1978 bear market periods. In these periods bond returns were weak at only 1.2 percent and 2.9 percent, respectively.It’s also worth noting that real yields, the ten year bond rate minus the inflation rate, were about three percent and two percent respectively at the start of these bear markets. This is much higher than today’s zero real rates. Predicting future inflation and interest rates is always difficult but we recommend using a laddered bond portfolio to reduce interest rate risk. Although highly rated bonds will not be able to provide the returns from the 2000-2002 and 2007-2009 periods, they are still one of the few negatively correlating asset classes providing portfolio protection and should be part of a balanced portfolio.Disclaimer: This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by Anchor Investment Management Ltd. to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results.